Cost segregation is the process of examining all the physical components of a property and classifying them based on their life expectancy for tax purposes. A major tax court case (AmeriSouth v. Commissioner (TC Memo 2012-67), March 2012) has resulted in the reclassification of many of the elements in the petitioner’s building from personal property to building.
By way of background, AmeriSouth purchased the market rate complex in 2003 for $10.25 million and spent $2 million in renovations. Consultants performed a cost segregation study that resulted in increased depreciation deductions of approximately $1.4 million from 2003-2005. The IRS Commissioner subsequently denied the deductions of more than $1 million. AmeriSouth then filed a challenge to the Commissioner.
In such cases, the burden of proof is on the taxpayer to provide support on why an asset should be considered to have a shorter depreciable life than the building itself (27.5 years for residential buildings). An important element of this case is that the Petitioner failed to produce evidence to support many of its positions, and in fact, failed to show up at trial.
The crux of the case was whether tangible property attached to a building may be claimed as personal property and/or site improvements (which have a shorter life) rather than be considered part of the building itself. The case reviewed a dozen categories of assets, and issued very interesting findings regarding some of these.
Underground Utilities
Issue: do underground utilities (e.g., water/sewer/electrical lines) relate to the “operation and maintenance of the apartments?” If so, they may be considered an integral part of the building since they serve the building “generally” by providing water, sanitation, gas or electricity to the building. In AmeriSouth, the court ruled that the underground utilities were part of the building, and thus depreciable over the 27.5 years. A key part of the decision appears to focus on what the utilities are connected to, who owns the lines, and who is responsible for maintaining them. So, based on this decision, utilities connected to the “building” would be considered part of the building, but utilities that run to exterior lighting or sprinkler systems could be considered site improvements and be depreciated over a 15-year period. Also, if a utility company owns and maintains the lines, the asset is not depreciable at all – even if located on private property.
Offsite Improvements
What about offsite improvements that an owner pays for, but then dedicates to the utility company? In IRS Technical Advice Memo (TAM) 200017046, a developer built streets, sewer and water systems, and storm drain improvements, and then deeded those improvements to the city as public improvements. The IRS position, as expressed in the TAM, is that these assets do not constitute depreciable property to the developer and are considered intangible assets. Under IRC §1.167(a)-3, an intangible asset with an unlimited useful life is not subject to the allowance for depreciation.
However, the IRS appeared to take a different position in at least one case. IRS Private Letter Ruling (PLR) 200916007 states that §1.263(a)-4(d)(8)(iv) provides that offsite infrastructure built by a “taxpayer where the real property or improvements benefit new development or expansion of existing development, are immediately transferred to a state or local government for dedication to the general public use, and are maintained by the state or local government” are considered “dedicated improvements.” Dedicated improvements are considered indirect, tangible assets and are depreciable the same as other depreciable costs of the project. While applicable only to the taxpayer for which it was written, this PLR is interesting in that it was specific to a LIHTC project. The Service found that “the costs directly benefit, or are incurred by reason of, the construction of the project. Therefore, the costs are indirect costs as defined in §1.263A-1(e)(3)(i), and are capitalizable to the property produced in the project.” The Service also stated in the PLR that these costs were includable in the project’s eligible basis.
Finish Carpentry & Cabinets
Examples of finish carpentry include shelving in pantry closets and living room wall recesses, wood-base, crown molding, chair rails, wood paneling, and closet rods. The governing case for determining an asset’s permanence is Whiteco Industries, Inc. v. Commissioner [65 TC 664(19750]. The court indicated that in determining the permanence of an improvement, there are six factors to consider, all of which relate to the ease of movability of an asset without causing damage to the underlying property, as well as the owners intention relative to permanency.
For a typical residential apartment building, such assets will likely be replaced numerous times over the 27.5 year life of the building. For example, baseboards may have to be replaced when carpet is replaced, and cabinets and countertops are subject to heavy usage and damage that will require frequent replacement. However, the AmeriSouth decision was that such elements are integral to the building, and are thus depreciable over the 27.5 year depreciable lifespan of the building. In its decision, the court decided that wood moldings, baseboards and paneling were not purely decorative, but provide protection for other parts of the building, such as floors, walls, and ceilings. For this reason, such elements are considered and “integral” part of the building.
When evaluating an asset’s depreciable life, consideration must be given to whether the element is primarily decorative, as well as its permanency. In general, if an item is primarily decorative (e.g., accent lighting, false balconies, faux fireplaces, etc.), it will be considered personal property, and depreciated over a five-year period. It is the taxpayer’s responsibility to support a position that an element of the building is decorative or non-permanent.
Sinks & Other Elements
One of the most aggressive positions taken by AmeriSouth was regarding the permanence of the sinks. AmeriSouth took the position that because the sinks are easy to remove, they should be classified as five-year depreciable personal property. The court focused on not how permanent a sink may be, but on whether or not the fixture has a special, singular purpose or use. While it is generally acknowledged that special equipment and appliances, as well as the piping, outlets and vents that serve such equipment, are personal property, the court stated, “providing water for the kitchen is hardly unusual… and AmeriSouth fails to give any other evidence that it is periodically replaced or even planned to replace sinks…” In this case, the sinks were classified as structural components of the building, subject to 27.5 year depreciation. The Court did rule that the five-year depreciation rule applies to vents that serve dryers in the laundry rooms, as well as the electrical outlets for washers, dryers, and refrigerators. However, vents over the kitchen stove were classified as part of the building, since the vents provide general ventilation of smoke, smells and steam from the kitchen, rather than directly functioning as part of the stove (which was classified as personal property).
While the AmeriSouth decision may be an “outlier” due to the fact that the taxpayer failed to provide any support for its representations, and owners of commercial property are entitled to depreciate assets over the useful life of the asset, the burden is on the owner to provide a cost segregation study that accurately reflects the desired classification of an asset. Key elements to focus on in such studies are (1) lack of permanency; (2) property that serves a specific piece of equipment (rather than the building itself); and (3) ornamentation.
Owners should be certain that the accounting firm retained to prepare cost segregation studies is experienced in this type of work and has a track record of being able to defend classifications when challenged by the IRS upon audit.